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The Truth Behind Many of Wall Street’s “Winners”

I have a confession to make. I like betting against companies. I enjoy it! There’s nothing more thrilling to me professionally than catching a company’s management team with their hand in the cookie jar and watching the stock price implode when their shenanigans are exposed. But, just because I’m a short seller doesn’t mean I’m a “permabear.”

There are appropriate times to allocate to stocks and there are times that aren’t so good. In my opinion, right now we are in one of the latter times.

That’s why I’ve written so much lately in my Thursday column for Economy & Markets that, right now, we’re in the riskier end of the spectrum, and allocating to equities at this point is likely to yield well below average returns.

In the past six years, the stock market has gone nearly straight up. To make money, all one had to do was buy the glossiest growth story and hang on for the ride. Many investors are still foaming at the mouth over these successes.

But, let’s take a look at what happened in one of the biggest bull markets of all time.

One of my favorite studies is called the Capitalism Distribution, which suggests a very small minority of stocks are responsible for nearly all of the market’s gains. It was presented by BlackStar Funds.

In it, they showed that from 1983 to 2007, the Russell 3000 was up 900%. But not all of those stocks were winners.

In fact, 64% of stocks under-performed…

39% of them outright declined…

19% fell by 75% or more…

And only 25% accounted for all of the market’s gains.

To a certain extent, that’s just capitalism.

For every Microsoft, there are 40 dead software companies that didn’t make it through the personal computing revolution.

For every Wal-Mart, there’s dozens of retailers that no longer exist because of inferior distribution, pricing power, and technology.

What’s more, the leaders from one cycle are seldom the leaders of the next. Kodak, General Motors, Polaroid, Bethlehem Steel and many other former giants were once core stock holdings that spiraled to $0. And that was during the best market of many of our lifetimes!

But that just goes to show, what looks like a winner may in fact be a loser waiting to happen.

And that’s the truth behind many of Wall Street’s “winners.” Sometimes, it’s strong fundamentals that send a company to publicly traded status and keep them there. Other times, these companies just know how to make themselves look good.

As a forensic accountant, I’ve boiled it down to a few simple things that can help you spot a real winner, from one that’s just really good at faking it:

Read the company’s quarterly and annual reports. Believe it or not, many professional investors skip the basic process of reading the SEC filings. That’s where all the bad stuff is buried. A little difficult to uncover if you’re not looking for it…

Track cash flow. Companies may report great earnings, but management cannot spend earnings. They can only spend what’s coming into the company’s coffers. If you compare quarterly cash flow to quarterly profits and analyze the trends, you’ll quickly see how the company’s actually doing.

Pay close attention to the quality of revenue. Did the company change its revenue recognition policy? Is it taking longer for them to collect receivables? Is the backlog piling up? When management teams play games with the revenue line, it usually indicates demand for their product is slowing. Revenue is far more important than earnings.

There are several other variables you can check to measure the true health of a company. How’s inventory? Is the company adequately selling their product, or is it piling up on the warehouse floor? Is the company experiencing an artificial profit boost by playing games with their margins? Is it making a series of incomprehensible acquisitions?

These are just a few pointers that you can look out for quarter-to-quarter to help spot trouble before it shows up in the stock price.
John Del Vecchio

In 2007, John Del Vecchio managed a short only portfolio for Ranger Alternatives, L.P. which was later converted into the AdvisorShares Ranger Equity Bear ETF in 2011. Mr. Del Vecchio also launched an earnings quality index used for the Forensic Accounting ETF. He is the co-author of What's Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. Previously, he worked for renowned forensic accountant Dr. Howard Schilit, as well as short seller David Tice.